Z score and its adaptation in MSME

Z score invented by Dr Ed Altman, Professor of Finance at New York University’s Leonard N. Stern School of Business to predict how likely a company is to fail. Altman Z score is a simple model determined by using 5 basic financial ratios. This gives a balanced view of financial health and economic stability of a company.

Z-Score = 1.2A + 1.4B + 3.3C + 0.6D + 1.0E

Where:

A = working capital / total assets

B = retained earnings / total assets

C = earnings before interest and tax / total assets

D = market value of equity / total liabilities

E = sales / total assets

Companies with Z-Scores above 3.1 are generally considered to be stable and healthy with a low probability of bankruptcy. Scores that fall between 1.8 and 3.1 lie in a so-called ‘grey area’ with scores of less than 1 indicating the high probability of distress. Z Score is used widely by financial auditors, accountants, money managers, loan processors, wealth advisers, as well as day traders.

Though it’s a simple model to determine BRE (Bond Rating Equivalence) and PD (Probability of default) Indian companies particularly MSME sector companies are not aware of it. This can be a lifesaver for MSME units and for the financial institutions dealing with them. Awareness needs to be created for using this simple model in the Indian scenario. Anyone interested in understanding and working with Z score can contact us.